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Don’t forget the fundamentals

All eyes were on Federal Reserve chairman Ben Bernanke last week as the Federal Open Market Committee held its June meeting, followed by a Bernanke press conference.

Let’s first remember how we got here.

In September 2012, the Federal Reserve launched its third round of quantitative easing (QE3), committing to buy $85 billion per month of agency mortgage-backed securities and Treasuries, increasing an already bloated balance sheet at the Federal Reserve (thank you, QE1 and QE2) to over $3.4 trillion.

Until last week, the exact timing of the end was left to pure speculation. That all changed with Bernanke’s opening press conference statement, as he telegraphed a possible timeline to the ending of QE3 (taper!).

The potential end of the sugar high was always bound to be met with some initial disruption. And, what a disruption it was, as the S&P 500 closed Wednesday down 1.4 percent for the day, followed by a 2.5 percent retreat on Thursday.

Short-term traders swiftly readjusted portfolios, as evidenced by the fact that ETF’s accounted for 41 percent of dollar volume in U.S. equity trading on Thursday, compared to a 24 percent average volume so far in 2013.

However, traders focus on headlines, while investors focus on fundamentals. Once investors step back from the short-term trading mindset and look at the fundamental reasons for the announcement, a different story could emerge.

Bernanke and the rest of the Federal Reserve, as evidenced by their statements, see a gradually improving economy. If the Fed’s forecast of the underlying economy is correct, that would be good for corporate earnings, which could be good for stock prices.

These trader-induced equity downturns could end up being more temporary in nature, with better days ahead.

While equities are in the midst of what could prove to be a temporary disruption, interest rate sensitive bonds (Treasuries being the poster child) appear to have entered a more permanent downward trajectory.

Consider that from Wednesday through Friday, the 10-year Treasury yield shot up from 2.18 percent to 2.51 percent. That three-day move translated into a loss of nearly 3 percent in the iShares Barclays 7-10 Year Treasury ETF (ticker symbol IEF) over the same three days. A 3 percent downdraft in risk assets such as equities is one thing; 3 percent downdrafts in “safe haven” assets such as Treasuries are a different story.

Those yields will only drift higher if the economy continues to firm. The opposite, of course, is true for yields if the potential economic recovery is just a mirage.

In summary, a Fed that is beginning to gradually remove support because of a firming economy can build a fundamental case for continued equity appreciation over the long-term, albeit with short-term term disruption as traders re-adjust.

On the other hand, the same Fed/economic scenario can build a bearish case for Treasuries that is both trading and fundamentally inspired.

More economic and earnings data will present itself in the weeks and months ahead to confirm the various possibilities. For now, we still think the relative fundamental story for equities is appealing.